What’s Behind Microsoft’s $8.5 Billion Takeover of Skype?

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Rumors that Facebook or Cisco would buy Skype were proven wrong on Tuesday when Microsoft struck an $8.5 billion deal — its largest ever — to acquire the online voice and video chat service. Most analysts have welcomed the takeover as a shrewd move on the grounds that it positions Microsoft in a commanding position in the emerging markets of video content and online telephony. Still, considering that Skype’s previous acquisition by eBay ended in a $1.4 billion write-down, questions remain about the deal. Will there be a good cultural fit between Microsoft and Skype? Did Microsoft overpay for a company that continues to lose money? Knowledge@Wharton discussed these questions and more with Wharton’s Eric Clemons, professor of operations and information management, and Kevin Werbach, professor of legal studies and business ethics.

Interview with Eric Clemons:

Knowledge@Wharton: Microsoft has just agreed to buy Skype for $8.5 billion, its biggest acquisition ever. What is the strategy underlying this acquisition? Do you expect the takeover to add value, or destroy value?

Eric Clemons: Acquiring high-tech companies, especially when there’s a great difference in culture or technology, can be a very risky play. This one makes profound sense for Microsoft. Of the three major players in cell phones, they are the third. They were the first in, and some people would say they’re now the third, after Apple and Google. If they’re going to succeed, they need to have something that offers some unique value. This [acquisition] may do this. If they can effortlessly merge Skype with the phone, then they have the best videoconferencing phone in the business. If they can effortlessly merge [Skype's] tech services with their own instant messaging service, then they have the best instant messaging system in the business.

It’s very different from the Facebook model, which is central. Skype is really peer-to-peer. Peer-to-peer scales — and in fact, it scales infinitely. Any pair of cell phones, any three cell phones, any five cell phones, can instantly be a Microsoft teleconferencing booth. It’s the kind of thing that may make the Microsoft phone make sense. It’s a play that’s intended to make their platform more distinguished, more powerful and more competitive.

Knowledge@Wharton: Does the price tag bother you? Did Microsoft overpay?

Clemons: Those are always difficult questions to assess. In one sense, they paid far more than the company is worth. In another sense, they may have paid no more than the company is worth to them. So somebody who doesn’t have a mobile platform to link [Skype] to doesn’t get the value they do. Somebody who already has a dominant mobile platform doesn’t get the value they do. If this makes their mobile platform more powerful, more attractive to consumers and more attractive to corporations, they’re really in a position to take the market from BlackBerry, and compete more effectively against Android. In which case, in hindsight, $8.5 billion looks like a very intelligent acquisition.

So the question isn’t whether the company was worth that to anyone else. It probably wasn’t. The question is whether in two years, or five years, we’ll think it was worth that to Microsoft. At least we know why they thought it might be.

Knowledge@Wharton: If we were to think back six years, when eBay paid $2.5 billion for Skype, it hoped to integrate it with their service and add value, but it was not able to do that. In fact, they took a $1.4 billion write-down before selling Skype to a group of investors. How do you think Microsoft will fare?

Clemons: What I’m going to repeat is unsupported or at least unknown to me — I haven’t verified this — but when eBay acquired Skype, they acquired Skype as is. They didn’t really acquire the intellectual property or the development team. Skype is a peer-to-peer instant messaging system. Peer-to-peer allows a buyer and a seller to completely bypass eBay. If eBay wanted Skype as a commercial infrastructure system, it would have had to be modified. If they acquired it without the appropriate intellectual property development team, it was of no use to them whatsoever. Again, I can’t back this up. If it’s true, I’m sure there are people who can back this up.

Similarly, my experience with Microsoft suggests that they’re much more experienced in technology acquisition. They’ve done this before. My guess is that if they want this to extend and integrate it, I’m sure they’ve acquired the appropriate people and intellectual property. That’s not to say they won’t have problems. Microsoft has a very centralized infrastructure, and [Skype] is a peer-to-peer communications system. There may be technology changes that have to be made. But in terms of preparation for the acquisition, they probably did a thorough job.

Knowledge@Wharton: Part of the concern is that even with 100 million customers a month using Skype, the company still loses money. They lost $7 million last year. Any thoughts on how Microsoft could tweak the business model to change that?

Clemons: There are different ways of making money. Somebody might argue that Google has hundreds of millions of users, and not one of us pays anything to use Google. There must be something profoundly wrong with their business model. Yet if you look at their income statement or balance sheet, somehow they’re making it work. So there are two possibilities. One is that Microsoft would expect to so thoroughly grow Skype’s core business that it became profitable. The other possibility is that this is an “input” for Microsoft’s other businesses, a way of Microsoft trying to generate some form of social network — possibly some commerce-based social network that’s different from Facebook. Or it’s something to leverage the value of the phone itself. It’s something to make a profitable business much, much bigger, and therefore much, much more profitable.

I wasn’t consulted. I wasn’t working with Microsoft. I don’t know what the strategy is. But there are three [possibilities]. One is to grow a profitable business with a platform-based strategy. The other is to make this bigger. A third is to hope to get lucky. My guess is, it was probably some combination of the first two.

Knowledge@Wharton: In your other writings, you’ve been an opponent of vertical integration in search. Why do you think this deal is safe?

In other words, if you are truly a dominant platform in search and you begin to subsume channel distribution, sales and things that you can lock people out of due to your power in search, that scares me.

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Right now, Microsoft’s mobile platform is among the weakest in terms of market share. Microsoft’s perception [as a player in] high-tech innovation is quite limited. Microsoft’s perception as a player in social networking is quite limited. This isn’t building on market domination to achieve second and third and fourth order market domination. This may be a very clever attempt at keeping Microsoft alive as a counterbalance to Google. If Google did it, this could be a way of squeezing out other players and eventually slaughtering them.

Knowledge@Wharton: You’ve referred a couple of times to Google and Facebook. How do you think this changes the competitive landscape for search and social networks?

Clemons: I’m not sure it changes social networking. If it did, it would change it in the following way. Mostly, right now, social networking is about broadcasting. You know, it’s not always Twitter. But if somebody wishes me a happy birthday, all of my friends can see what everybody else had to say. It’s a broadcast kind of thing. And I guess it’s fun. Skype is much more focused. I have something I need to do. I’ve got two guys in Singapore I need to do it with. I’ve got a guy in Beijing and a guy in Shanghai. Two, three or four of us get together, and synchronously we videoconference. I show him a picture; he shows me his notes. That’s a very different kind of social networking.

That’s not what Facebook is used for now. It’s much more collaborative, focused work. That may be a marvelous application of Skype. If Microsoft wanted to, [it could] introduce a tablet, something to compete with the iPad, and combine Skype with something that’s really quite difficult to do nicely on the iPad, which is PowerPoint. If I can be Skyping and PowerPointing with two or three co-workers, that’s a different kind of social network.

I can see things that shouldn’t scare Facebook, but should make a Microsoft investor quite happy. That’s one possible use for this.

Google probably has nothing to fear from this. If Microsoft did a wonderful job with this — introduced their own “M-pad” and integrated it with Microsoft software — it’s possible that this is the start of “social search.” In other words, [it's not about] who bought top billing, but what did my friends like and dislike? What did my friends give a high-five to? What did my friends throw a rotten tomato at? If it doesn’t do that on an individual basis but on an aggregate basis, this might be a way to integrate being with my friends, because I now have my contact list for Skype. But right now, most of us have pretty short contact lists. So social search isn’t going to come immediately out of Skype.

Knowledge@Wharton: What will this deal mean for consumers? Are the days of free Skype calls coming to an end?

Clemons: I don’t see why that should be true. If we think about the way Google operates, any time you can make something free to a consumer that makes something else more valuable, it’s worth doing. It’s possible that the monetization would involve a permanent surcharge. But it’s also possible that if this enables Microsoft to sell tens of millions more mobile phones, and that’s tens of millions more mobile operating systems, and — if they go to an M-pad — tens of millions more copies of PowerPoint, they don’t have to charge consumers for this. It can be that essential start of a new platform strategy.

Interview with Kevin Werbach:

Knowledge@Wharton: Microsoft has just agreed to buy Skype for $8.5 billion dollars, its biggest acquisition ever. What do you think is the strategy underlying this acquisition? Do you expect it to add value, or to destroy value?

Werbach: For Microsoft at this stage, there aren’t many acquisitions that would really be big enough to create the kind of opportunity that the company needs. It’s a huge, successful company. But to build new lines of business outside of Windows and Office, it needs to find really huge opportunities. The transformation of communications is that kind of massive opportunity. Microsoft, as most people know, has large businesses in software. It has also got a significant franchise now with the Xbox. But they’re looking at new ways to monetize and grow that.

Clearly, voice communication and video communication over Internet technologies are exploding in popularity globally. The opportunity to marry that kind of communications function with the software and content functions that Microsoft has already, creates the potential for a big opportunity. Whether or not it will be successful depends on how well they execute on it. I thought when Skype was acquired by eBay a few years ago that had the potential to be a successful, synergistic deal. And it wasn’t. Not because the strategy was fundamentally flawed, but because eBay never really successfully executed on it. The challenge for Microsoft will be to figure out if they can bring in the user base and the technology that Skype has to their existing offerings.

Knowledge@Wharton: What did eBay not do right, and what lessons can Microsoft learn from eBay’s failure?

Werbach: One thing eBay did right was that they took Skype from what was at the that point a fairly disorganized startup and made it a well-run business that has scaled in revenue and moved closer to sustained profitability, which is not something necessarily easy to do — especially when taking over from the founders and scaling up to involve new people.

But eBay was never successful at deeply integrating the real-time communications capabilities of Skype with the eBay auction and commerce and payment offerings. I don’t know enough [about eBay] internally [to say] why that didn’t happen. They had laid out a road map at the time they did the acquisition about click-to-call and various opportunities, and it never really quite panned out.

A lot of it was cultural — eBay, even though it’s a technology company, is in many ways a very traditional company, and not in a bad way. It’s an incredibly successful company. It’s a company that understands small business, sales and marketing, and scaling commerce around physical goods. Skype is an entirely virtual company. It’s a global company, with operations in Eastern Europe and places like that. It’s a feisty startup. So I don’t think there was ever a good cultural fit. Now, the query is whether there will be a good cultural fit with Microsoft.

It’s certainly easier to see the overlap with Microsoft because it’s a software company at heart. I could see that working. But it’s not a slam-dunk. It never is with an acquisition of this scale.

Knowledge@Wharton: Does the price worry you? Did Microsoft overpay?

Werbach: At the kind of scale that Microsoft is playing at this point — again, the opportunity has to be big enough to move the needle at a company of Microsoft’s size — if they overpaid by a few billion dollars, the opportunity they’re going after with Skype is in the tens of billions of dollars annually. That’s not going to matter at the end of the day, if they’re successful. If they’re not successful, whether they paid a few billion more or less, given the kind of cash position they have on hand — in hindsight, one can analyze it in terms of shareholder value [and whether there was] another use for the money — strategically, I don’t think that’s the biggest variable.

Knowledge@Wharton: Part of the concern is that even though Skype has more than a 100 million customers each month, it’s still losing money. Last year, it lost $7 million. How will Microsoft have to modify its business model to move it into the black?

Werbach: There are two ways of looking at that. One is the business model for Skype. What’s the business model for real-time, IP-based communication? There clearly is revenue. Skype’s making close to $1 billion a year. It’s just, as you say, they haven’t been profitable. Part of that is scaling and part of that is the substantial costs they have to pay existing telecommunications carriers typically for the “last mile” of [telecommunication]. The communications industry is ripe for very significant disruption. It’s a $1 trillion global industry that’s built on legacy infrastructure, legacy business models and legacy regulatory structures.

Skype, because it doesn’t have that legacy baggage, is in as good a position as anyone to be one of the successful companies that comes out of that transformation. That doesn’t guarantee that it’s a successful business. But the fact that Skype has the scale and is as big as or bigger than any traditional carrier, without the encumbrances of those legacy business models, gives it an opportunity. In particular, the growth of video — which is already now something like 40% of usage on Skype — is a big opportunity because there’s more value that can be driven through it. There’s more opportunity to do things like advertising, services that people pay for and so forth.

The big opportunity, though, in this deal for Microsoft is not, “Can they build Skype into a profitable standalone company?” It’s, “Can they find opportunities to inject Skype into everything else they do?” and create better value propositions that they can then monetize on top of their cloud-based software offerings, on top of Bing and so forth. We’ll see. I don’t know exactly how they’re going to do that. But those are massive revenue-generating platforms, where one could certainly see the potential that adding in those real-time voice and video components would be significant from a financial standpoint.

Knowledge@Wharton: Continuing along the same lines, if Microsoft were to integrate Skype’s technology to enhance collaboration at the enterprise level, is there a risk that it could end up stifling the factors that have made Skype so successful?

Werbach: There’s always risk in any kind of acquisition like this. Microsoft is a company that people have very strong feelings about. So certainly there’s always some risk that way. But let’s remember, Skype is not, at this point, a tiny, swashbuckling company. It’s a very substantial operation, which has gone through the process when they were owned by eBay — and then subsequently spun [off] — of bringing in professional management, who understands how to scale and run these kinds of businesses. There’s always the possibility with technology deals of this scale the likelihood that there’s going to be some clash. But what motivates the engineers at Skype, as I understand it, is the big scale of the opportunity — the technical challenge and the ability to change the world by connecting several billion people is what they’re going after. To the extent that Microsoft facilitates them doing that, I think that will be something they will continue to be excited about. To the extent that Microsoft doesn’t provide that kind of opportunity, they’ll lose people.

Knowledge@Wharton: Before Microsoft and Skype did this deal, there was discussion about a possible acquisition by Facebook or Cisco. Looking broadly, how does this change the competitive landscape for both telephony and social networking?

Werbach: It’s clear that real-time communications in a particular video are going to be a major piece of the puzzle for a large number of technology companies. If you look at some of the major competitors, Google already has YouTube. They already have Google Voice. They’ve already got a massive fiber optic network globally as infrastructure. Cisco has their telepresence offerings, and the former WebEx business, the former Linksys business and a number of these pieces as well. Facebook has a very substantial messaging component as part of social networking but doesn’t have its own direct infrastructure for this sort of thing. Facebook, though, has a strong partnership with Microsoft.

To the extent that a company like Microsoft wants to be a player in all dimensions of this kind of communications and technology space, both on the consumer side and the enterprise side — which clearly I think they do — having a strong portfolio in voice and video is important. But again, it depends on the culture of the company, and their strategic market position. What Skype means to eBay is different from what it means to Microsoft. What it means to Microsoft is different from what it would have meant to any of the other possible acquirers.

Knowledge@Wharton: What will this deal mean to consumers? Are the days of free Skype calls coming to an end?

Werbach: I don’t think free Skype calls are going away, because the competitive market still allows for that and because voice really is cheap. At the point where things get to be all digital … the constraint is bandwidth. And voice takes very little bandwidth. The [proposition] is the opportunity to terminate on the public switch telephone network. That’s what Skype charges you for when you call in from the phone network, which has nothing to do with the economics of the service. It has to do with that legacy regulatory system, and as the end points move more to PCs and mobile devices running things like the Skype mobile client, that will go away. It’s more about the value-added services and the extent that customers get more value, whether on the consumer side or the enterprise side, they’re willing to pay for that.

But the ability to make a phone call is increasingly just the “table stakes.” That’s the transformation. That’s the disruption. The phone call is the foundation of this massive, traditional telephone system globally. That’s going to be the thing that gets given away for free. But there are other things that layer on top of it — more conferencing and other features, and tighter integration with software and location and mobility, and so forth. That’s where the opportunity for the revenue is.

Knowledge@Wharton: Do you have any other final comments?

Werbach: One dimension of this is the policy dimension. While I don’t think that there will be any significant regulatory impediments to this acquisition, it will put more pressure on regulators to confront a question that they’ve been putting off for more than a decade: How do you bring together [Voice over Internet Protocol, VoIP] with the legacy regulatory system? I worked at the [Federal Communications Commission] in the 1990s, and the FCC at that time in the U.S. consciously decided not to apply traditional telephone regulation to voice over the internet, because it was a nascent industry and looked different. But once you’re at the point where a Skype is worth $8 billion, is part of an established company like Microsoft and is being used increasingly to compete directly with traditional telephone companies, which themselves are moving their back-end technology to Internet protocol, we need to confront these regulatory imbalances.

Does it mean that we should apply all the old rules to the new technology? In fact, we need to rationalize the regulatory system to avoid that happening by accident. While this deal doesn’t directly change anything, it puts much more pressure on the regulators in the United States and elsewhere to confront some of those questions.